Question
A company is considering the development of a new product. The first step would be to do a feasibility study, which would cost $300,000 today.
A company is considering the development of a new product. The first step would be to do a feasibility study, which would cost $300,000 today. If the outcome of the feasibility study is favorable, then the company would build a prototype, which would cost $800,000 one year from now. The probability that the feasibility study outcome will be favorable is estimated to be 65%.
If the prototype is successful, then the company would build a manufacturing plant, which would cost $6 million two years from now. The probability that the prototype will be successful is estimated to be 70%. If the prototype is unsuccessful, then the company would sell it for $300,000 two years from now.
If the product is manufactured and offered for sale, the probability that the demand will be high is estimated to be 60%, in which case the present value of the future cash flows is estimated to be $20 million three years from now. The probability that the demand will be low is 40%, in which case the present value of the future cash flows is estimated to be $6 million three years from now.
If the companys weighted average cost of capital is 10% per year, what is the net present value of this product? What should the company do?
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